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Next Budget will be acid test for new govt

Next Budget will be acid test for new govt
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First Published: Mon, May 18 2009. 12 30 AM IST

Updated: Tue, Jan 19 2010. 03 18 PM IST
In its election manifesto, the Communist Party of India (Marxist), or CPM, said it would “reverse moves towards full capital account convertibility” and reimpose “strict controls on the outflow and inflow of finance capital”. Among other things, it wanted to ban the use of participatory notes (PN) by foreign institutional investors and halt “any further dilution of government equity in public sector banks”. PNs, essentially derivatives that change in value depending on the performance of underlying securities, allow overseas funds to invest in the country without having to register locally.
The CPM’s wish list also included scrapping the amendment to the Banking Regulation Act, 1949, and the proposed legislation to increase foreign direct investment in the insurance sector, currently capped at 26%. The amendment to the Banking Regulation Act is being proposed to remove the cap on voting rights. This is pegged at 10% in private banks and the plan is to change it so that voting rights reflect actual ownership.
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The Bharatiya Janata Party’s manifesto promised to waive all agricultural loans to make India’s farmers debt-free and cap the interest rate at which banks lend to farmers at 4%. Currently, farm loans of up to Rs3 lakh are given at 7% with the government offering a subsidy of 2 percentage points to banks.
The Congress election manifesto did not have much to say on economic policies beyond citing its special focus on small entrepreneurs and small and medium enterprises, and commitment to maintain “high growth with fiscal prudence and no inflation”.
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The next budget will be the acid test for the new government because it will have to strike a balance between delivering on its election promises and reining in the rising fiscal deficit. The combined Union and state government fiscal deficit is expected to be around 11% of India’s Rs54.3 trillion gross domestic product (GDP) in 2009, including oil and fertilizer subsidies.
The outgoing government announced three stimulus packages to prop up a slowing economy and, collectively, they account for about 3% of the country’s GDP. Many believe that the new government would announce yet another stimulus package of up to 1% of GDP. If indeed that is done, the fiscal deficit will rise further and the country will run the risk of being downgraded by rating agencies.
The challenge before the new government is unwinding the fiscal concessions as otherwise these, combined with the expansionary monetary policy of the Reserve Bank of India (RBI), will add to inflationary pressures. The Wholesale Price Index, India’s most widely tracked weekly inflation index, is 0.48%, but the Consumer Price Index that reflects the price of goods at the retail level continues to remain very high. RBI has brought down its policy rate from 9% to 3.25% and released at least Rs3.9 trillion worth of liquidity into the banking system through various measures since September, after the collapse of Lehman Brothers Holdings Inc. plunged the global financial system into an unprecedented credit crisis.
As inflationary pressures mount, another challenge before the new government will be keeping interest rates low. RBI has already brought down its policy rate below the administered savings rate and it doesn’t have much headroom to lower it further. Commercial banks are finding it difficult to pare their loan rates as they are unable to prune the rates they offer on deposits. This is because the rates on various small savings schemes run by the government are relatively high—8%. A lower small savings interest rate will encourage banks to cut their deposit rates aggressively. This will bring down their cost of money and pave the path for lower loan rates.
Even though the new government will not depend on the Left for survival, it may not be in a hurry to push for the removal of the cap on voting rights and reduce government holdings in public sector banks that account for around 75% of India’s banking assets. The move to amend the Banking Regulation Act came in 2003. The government had made clear that it intends to lower its holdings in public sector banks even earlier, in 2000. Then finance minister Yashwant Sinha had announced a plan to bring down the government holding to 33% with a caveat that the government would retain management control over public sector banks, making sure that the reduction of its stake would not lead to privatization. Under existing norms, the government’s stake in these banks cannot drop below 51%. In some of them, the government’s stake is close to 51% and unless the law allows it to go below this level, these banks will not find it easy to raise capital from the markets. Despite this, the government will not be in a hurry to pare its stake as state ownership of banks has become a way of life for the financial system after the global meltdown. But it can certainly raise the foreign ownership in private insurance firms from 26% to 49% as these firms need capital, and under Indian corporate law, a 49% holding does not give any special power to the stakeholders in running the company.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as a deputy managing editor of Mint. Please email comments to bankerstrust@livemint.com
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First Published: Mon, May 18 2009. 12 30 AM IST